New monetary season

For the financial markets, summer’s end is often the occasion for deep-felt upheavals. The fierce battles over the US debt ceiling come to mind, as well as the turmoil unleashed by the unexpected devaluation of the Chinese yuan in 2015. This summer, investors left on vacation filled with trepidation about the economic impact of Brexit, about robust job creations in the US and how they might change monetary policy prospects, and about the outcome of European banks’ stress tests. In the end, the financial markets were surprisingly bullish, with Wall Street reaching new heights, emerging market and corporate bond yields dropping sharply and Italian and Spanish long-term yield spreads narrowing relative to their German counterparts. The central banks – along with expectations about their upcoming decisions – played a key role in these developments. The Bank of England reacted boldly to cut short the prospects of an economic downturn. In an environment marked by the perpetual search for returns, the BoE’s decision to launch a new round of QE also weighed on the long-term rates in other countries. ECB and BoJ monetary policies also helped fuel this movement. Abundant liquidity, coupled with expectations that the Fed would maintain a cautious approach to monetary tightening, explain why US Treasury yields reacted so mildly to the recent series of particularly strong employment figures. This behaviour, combined with the prospects of stronger H2 growth, helped buoy the US stock markets.

Will the new monetary season be as calm as during the summer break? Nothing could be less certain, especially since market expectations risk being disappointed by the central banks’ actions (or lack thereof). September’s agenda is marked by an ECB meeting on the 8th, and by BoJ and Fed meetings on the 20th and 21st. Given the inertia of core inflation, and despite a resilient economy, we expect the ECB to take new measures, including the extension of its QE programme by at least 6 months, until September 2017. With its manoeuvring room diminishing as the months go by, it is becoming increasingly difficult for the central bank to surprise the markets in a positive manner, notably the forex market. Consequently, it is not surprising that the ECB leaders are making fewer declarations, while trying to prevent expectations from rising too quickly. This communications policy might have been inspired by the Bank of Japan’s unfortunate experience following its latest monetary policy meeting, when analysts were disappointed that it opted solely to increase ETF purchases. The BoJ’s big challenge now is to prevent the yen from appreciating again. It too has very little manoeuvring room. The introduction of a negative rate drew sharp criticism; it has a gigantic weighting in the market for government securities; and there are reasons to doubt the effectiveness of ETF purchases. Lastly, looking towards the US, 2 September job market figures will play a key role in any eventual key rate increases. Recent statements by several Fed governors seem to support monetary tightening: job creations are much stronger than necessary to maintain unemployment at the current level, which is already very low. If key rates are raised, then it would bolster the dollar, which is sure to please the Europeans and Japanese. For the moment, the markets do not really believe much in a September tightening move. Are they being too complacent? Unless, of course, they believe it will not change things much, especially since the Fed insists on a structural decline in the potential growth rate. To cite Jerome Powell, one of the Fed Governors, this implies that the neutral level of interest rates is not only much lower than in the past, but also that current policy is not as expansionist as it might seem. Consequently, the cumulative tightening phase is likely to be fairly mild this cycle, which should enable the bond and equity markets to breathe easier as they anticipate future Federal Reserve meetings.

William De Vijlder

Director of Economic Research, BNP Paribas

23 August 2016